The plaintiffs' bar discusses auditor performance.

by Goldwasser, Dan L.

Abstract- A round-table discussion with attorneys representing litigants making claims against accountants and auditors was conducted by the New York State Society of CPAs. Based on the talks, the areas of weakness of most auditors were found to lie in their independence, performance and internal control reporting. The attorneys also saw no need for tort reform regarding accountant's liability and were not responsive to the profession's interest in limiting their vicarious liability by rendering services for limited liability companies or general corporations. The participants also made recommendations on the issue of independent accountant-client engagement, including the development of stricter regulations ensuring the accountant's independence, improving consultation and inspection methods for quality control, initiating a system for recognizing competence of firms to do audits. The panelists were David Bershad, Marian Rosner and Edward Labaton.

The news of settlements and awards against accountants and auditors
arising out of litigation has tarnished the public's image of the CPA.
While the size of some recent awards has blown the significance of
litigation out of proportion to the number of suits, the consequences
can not be ignored. This discussion with attorneys representing those
making claims against accountants was conducted to help identify steps
the profession can take to reduce its exposure to claims and improve its
standing in the public eye.

Attorneys, as do accountants, break their practices into specialized
areas. Such a specialty exists in the area of accountants' malpractice.
Attorneys with this specialty frequently represent plaintiffs who allege
they have been wronged or damaged because of an accountant's or firm of
accountants' failure to discharge their duties in accordance with
professional standards.

The New York State Society of CPAs, in a second of a series of round-
table discussions, met with members of the securities industry
plaintiffs' bar in an effort to provide insights into the performance of
the accounting profession from those that have direct contact with it.
The attorneys that participated are principally involved in actions
involving losses claimed under the Federal securities' laws.
Participating were David Bershad, Milberg Weiss Bershad Hynes &
Lerack; Daniel L. Berger, Bernstein, Litowitz, Berger & Grossman;
Marian Rosner, Wolf Popper Ross Wolf & Jones; and Edward Labaton,
Goodkind Labaton Rudoff & Sucharow.

Dan L. Goldwasser, editor of The CPA Journal's Accountants Liability
Department and frequent defender of accountants against malpractice
claims, led the discussions. For many of the subjects, unanimity of
opinion among the panel of attorneys did not emerge. The highlights that
follow attempt to capture the prevailing feelings of the group with
differences of opinion noted when significant to the topic.

Independence

In examining the performance of accountants as independent auditors, it
became clear from the discussion that independence is an issue in many
legal proceedings against auditor performance.

Biting the Hand That Feeds. A common sequence in the courtroom in the
view of the panel finds juries initially quite impressed with the
accountants on trial. They present themselves well, in dress and
conduct. The jurors have no preconceived notions about them.

As the typical trial proceeds, however, jurists become concerned about
the relationship between the independent accountant and his or her
client because of the way the accountant is compensated. Since the
client pays the fee, the jurors become skeptical about whether the
independent accountant was able to take tough stands and seriously
question management about what the audit revealed. When substantial
audit fees are involved, which continue at the goodwill of the client,
it is only human nature for independence and skepticism to come under
question.

The independence question in this context is not a function of the
performance of the particular accountant on trial; it touches upon the
fundamental nature of the auditor/client relationship. In effect, the
lawyers are saying the defending accountant may be coming to bat with a
built-in one-strike count.

Consulting Services. The attorneys noted instances where independent
accounting firms that provide consulting services to audit clients find
themselves in problematic situations. In one scenario, a client engaged
consultants from the auditing firm to "fix" a problem. The consultants
in the process learned of conditions that, if known by the auditing side
of the practice, would have affected the nature and extent of the audit.
But the consultants did not communicate the conditions to the audit
team. Was this a failure to communicate? Or did the firm not wish to
jeopardize future "fix" engagements that might not come if management
felt that the audit opinion might be adversely affected?

Consulting engagements were also noted to be a device to keep the audit
firm "in tune" with the objectives and goals of the client. One attorney
noted a situation where whenever the auditor began to pursue a "red-
flag" condition, management would find an additional MAS engagement for
the firm to provide.

The advice to the profession from the attorneys was not to undertake
management information engagements for audit clients where the MIS fees
become disproportionately large in relation to the audit fees.

Dominant Client. The performance and independence of a firm also comes
into question in litigation if the audit fee for the engagement being
challenged comprises a substantial part of the firm's total fees.

Performance Deficiencies

Sooner or later in the litigation, said the panel, the quality of the
work done and the overall performance of the audit will be the focus of
attention.

Ought to Know. Very often the defendant accountant will be asked to
explain why certain events and transactions were not detected or
otherwise brought to the surface. The accountant will defend his or her
performance by claiming the audit was performed in accordance with
professional standards, and an expert will agree with that position. An
expert for the plaintiff will assert that the firm did not go far enough
considering the "red flags" that were readily apparent.

The issue will be decided when the jury determines if the defendant
should have known and communicated the error, or wrongdoing.

In this connection one attorney expressed the view that the standards of
the accounting profession appear to be established to shun
responsibility. When confronted with a fraud situation, the accountants
offer as a defense that their audit cannot be expected to detect all
fraud. It should be recognized that the SAS 53, Auditor's Responsibility
to Detect Fraud and Other Irregularities has not been in effect
sufficiently long to have a noticeable impact on most court actions with
which this group of attorneys would have been involved. This SAS was
designed to close the expectation gap in the area of fraud detection.
Recent statements by the AICPA have indicated its plans to explore
additional ways to make the audit process more effective in detecting
fraud.

Along this same line, another attorney observed that independent
accountants never admit to any deficiencies or shortcomings in their
work. Whenever confronted with a finding of irregularity or other
problem, the auditor says, "We weren't supposed to find that." The
attorney acknowledged that the accountant would not be expected to admit
to any wrong doing, but felt that auditor disclaimers are often just not
reasonable.

The attorney went on to question why auditors are needed if they can't
reveal irregularities. Too often the audit seems to have merely skimmed
the surface.

One attorney noted that often the red flag signaling the irregularity
was properly noted and described in a memo written by a bright young
staff accountant. However, somehow the facts and circumstances were
never properly dealt with at the supervisory level.

Review Notes. Another attorney expressed dismay over the treatment
afforded review notes created in the performance of an audit. Most of
the major firms have a policy of destroying these notes to prevent them
from becoming a road map to problems in the event the audit ever becomes
the subject of litigation. This gives the perception that the auditor is
seeking to shirk responsibility by preventing injured third parties from
knowing what the audit review process revealed.

Opinion Shopping and GAAP Problems. The attorneys also noted the
selection of a "favorable" accounting treatment is more of a problem
than bad auditing or overlooked management fraud. Auditors find
themselves in difficult situations when the method of accounting is not
appropriate for the circumstances or not adequately disclosed. The panel
strongly stressed the importance that the accounting treatment should
portray the economic reality of the transaction.

One of the very real danger signs on the road to litigation is a switch
in method of accounting that presents a more favorable financial result.

A common GAAP problem noted by one attorney is in the area of
percentage-of-completion income recognition on long-term contracts. It
also becomes a GAAS problem when the auditor attempts to deal with
management's estimates of costs to complete.

Other Performance Deficiencies. The panelists discussed the following
other deficiencies that cast a dark shadow over the audit conclusion and
the proper performance of engagements:

* Young and inexperienced staff doing the audit work in important and
complex areas, or in some cases the staff assigned are not sufficiently
dedicated or bright to uncover the problems lying beneath the surface.

* A lack of adequate supervision of the work done by less experienced
staff.

* A lack of training and experience of the audit team in the industry
in which the client operated. In this regard, the first engagement in a
highly specialized area can be particularly hazardous.

In an attempt to put the matter of auditor performance in perspective,
one attorney expressed the view that in many cases the auditors are well
schooled on the issues and are trying to do a good job. What traps them
are inadvertent false steps, the kind that are very difficult to avoid.

In supporting this point, an attorney observed the plaintiffs' bar
exists because of human nature. Companies come under pressure to perform
and begin to do things they normally wouldn't consider. They begin to
bend the rules in their favor or take a very optimistic position on
matters of uncertainty. Actual fraud is very rare. Unfortunately, "The
Crazy Eddies of this world will never be eliminated," said one attorney.

Internal Control Reporting and Other Matters

Mr. Goldwasser asked the panelists to comment on a number of matters
facing the profession.

Auditors' Reports on Internal Control. The panelists did not think
reports to shareholders on the effectiveness of a company's internal
control structure would contribute to better financial reporting or
improved public confidence. They felt the public does not know what
internal controls are all about. Such reports would be of more use to
analysts.

Whistleblowing. The lawyers recognized the awkwardness of the accountant
informing third parties about audit findings. They acknowledged that
with regard to public companies there is a way (through a SEC Form 8-K
filing reporting a change in auditors), to inform third parties about
disagreements between auditors and companies. No solution emerged from
the discussions.

What is just as difficult and just as important, noted one attorney, is
to blow the whistle within the firm when a partner is not doing his or
her job.

The attorneys noted comparability on this issue between CPA firms and
law firms. Both professions are grappling with their responsibilities to
inform third parties. The public envisions the CPA as a watchdog; the
panelists admitted that this expectation may be unreasonable.

Overselling of the Assurances of Audits. The attorneys generally did not
believe auditors and the profession oversold the worth or effectiveness
of an audit. An auditor's seal of approval or unqualified report does
not promise more than it reasonably can deliver. A problem was noted in
the area of tax shelters. An opinion about the "more likely than not"
deductibility of an expense or existence of a tax credit thrust many
CPAs into tenuous and litigious situations. Investors put a lot of
weight in those kinds of opinions, and when those tax benefits did not
materialize, law suits proliferated.

Forecasts and Projections. The public has a tendency to place too much
worth on those reports. Because of the nature of forward looking
financial information, the attorneys said that if the CPA is going to
get involved, the work must be carefully and thoroughly done. One noted
having seen engagements related to future-oriented financials where the
testing of assumptions was skimpy at best.

Audit Quality and Firm Size. The attorneys felt that generally firm size
was not a determinant of audit quality, until the very small firms come
into the picture. Firms of 50 to 100 can do just as competent a job as
the very largest firms.

Tort Reform

The attorneys, as might be expected, did not see any compelling reason
for tort reform with respect to accountant's liability. They feel the
possibility or threat of serious consequences for poor performance
contributes to the overall quality of services being performed. It
motivates the firms to be tough, realizing the potential financial loss
could be catastrophic. To limit the potential financial risk to the
amount of the audit fee or some multiple thereof would not serve the
public interest in their opinion.

There are enough factors in the process, say the attorneys, to protect
the auditor without reform. There is the doctrine of privity in New York
and now California. In Federal securities cases there is the need to
establish scienter, which is not always that easy. And courts are on
their own are moving towards proportionate fault and liability in
settlements. There has been a shift in many court rooms making it more
difficult to prove against the accountants.

The lawyers went on to comment that since mere negligence is not
sufficient to be successful against an accounting firm, joint and
several liability is a legitimate operating factor. If you perform in a
grossly incompetent fashion, the consequences should be severe.

The lawyers had no particular feeling about the chances of achieving
tort reform but indicated the U.S. Supreme Court may rule on it.

The attorneys expressed their view that the accounting profession, with
its huge numbers when compared to the plaintiffs' bar, has significant
clout in seeking legislative change. But, they repeated, that would not
be in the public's interest.

Limiting Liability in the Form of Practice

The attorneys were generally indifferent to the profession's interest in
limiting vicarious liability--the exposure to personal liability for
misfeasance of another partner--through practicing in limited liability
companies or general corporations. It was their experience that any
financial loss was limited to the assets of the firm, and no claims were
made on the personal assets of the partners.

Moderator Goldwasser asked the group to consider the following
consequences in reaction to the heavy liability exposures:

* CPA firms contract and limit their practices because of a lack of
qualified staff; and

* The profession becomes unattractive and loses stature in the eyes of
the public.

The attorneys felt the picture painted was far too bleak. They also did
not see any particular dramatic increase in the number of cases in which
CPAs are involved. Also if a case against a CPA is not strong, they do
not pursue it.

Recommendations

During the discussions, the panelists considered areas for improvement
in the basic nature and structure of the independent accountant/client
relationship.

* Establish more stringent rules to protect the independence of the
accountant. One way is to require the auditor to communicate findings to
an independent authority at the client, typically an audit committee or
the board of directors. In the smaller, privately held company this is
often a problem. The board and active management are the same, and they
do not want to hear problems.

* Strengthen the consultation and inspection elements of the quality
control system. Along these lines an attorney suggested the benefit of
an immediate in-depth, inspection-like review of engagements that appear
problematic based upon pre-established criteria. Criteria might include
events such as the audit partner leaving the firm to become employed by
the client, the client experiencing cash flow and operating problems, or
fees exceeding a certain amount. When the event occurs, the engagement
would be subject to a complete detailed review by accountants within the
firm not directly associated with the engagement, but knowledgeable in
the industry. The attorney noted that often second partner reviews, or
independent partner concurring reviews, were perfunctory.

* Introduce a process to certify firms competence to perform audits of
SEC reporting companies. It was the view of one attorney that membership
in the SEC practice section of the AICPA Division for Firms was not per
se providing the assurances that the member firm was sufficiently
knowledgeable or qualified to perform these types of engagements.

* Encourage greater selectivity on the part of firms in choosing
clients to serve. One attorney noted a new breed of exposure that comes
from associating with "scum" companies. Having a firm's name associated
with what turns out to be the wrong kind of client can be very
detrimental. Given the time lag between when an audit or service is
performed and when litigation might take place, by this time accountants
know better than to associate with clients of questionable character.

The Plaintiffs' Bar Point of View

The attorneys were frank and helpful in discussing the issues that face
the profession. Their point of view is obviously affected by their
objectives and the cases they see. Nevertheless there is much to be
learned from them. In addition, many of their recommendations and
comments have appeared in the recent recommendations of the Public
Oversight Board and the AICPA to improve financial reporting and public
confidence.

ABOUT THE PANELISTS

David Bershad, Esq. is a partner of the firm of Milberg Weiss Bershad
Hynes & Lerack, a firm specializing in re-presenting plaintiffs in
securities litigation.

Marian Rosner, Esq. is a partner of the law firm Wolf Popper Ross Wolf
& Jones which specializes in securities and class action litigation.
Ms. Rosner is co-chair of the firm's securities litigation department.

Edward Labaton, Esq., is a partner of the law firm Goodkind Labaton
Rudoff & Sucharow. In addition to his efforts there, Mr. Labaton is
a member of Association of the Bar of the City of New York's Committee
on Securities Regulation.

Daniel L. Berger, Esq., is a partner of the law firm Bernstein Litowitz
Berger & Grossman, which specializes in prosecuting securities fraud
class actions and other commercial litigation. Mr. Berger also served as
an assistant attorney general for the State of New York from 1979
through 1983.

Dan L. Goldwasser, Esq. is a partner of the law firm Vedder Price
Kaufman Kammholz & Day and the editor of The CPA Journal's
Accountants' Liability Column.

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